Risks in Selling Short when Day Trading

Shorting stocks carries certain risks because a short sale is a bet on things going wrong. Because, in theory, there’s no limit on how much a stock can go up, there’s no limit on how much money a short seller can lose. Two traps in particular can get a short seller. The first is a short squeeze due to good news; the second is a concerted effort to hurt those who are short.

Squeeze the stock

With a short squeeze, a company that has been popular with a lot of short sellers has some good news that drives the stock price up. When the price goes up, short sellers lose money, and some may even have margin problems. And the original reason for going short may be proven to be wrong.

Those who are short start buying the stock back to reduce their losses, but their increased demand drives the stock price even higher, causing even bigger losses for those who are still short. Ouch!

Call back the stock

All is not sweetness and light in the world of short selling. Many market participants distrust those folks who are doing all the careful research, in part because they are often right.

Company executives are often optimists who don’t like to hear bad news, and they blame short sellers for all that is wrong with their stock price. Meanwhile, some short sellers have been known to get impatient and start spreading ugly rumors if their sale isn’t making money.

Many companies, brokers, and investors hate short sellers and try tactics to bust them. Sometimes they issue good news or spread rumors of good news to create a squeeze.

Other times, they collectively ask holders of the stock to request that their brokerage firm not loan out their shares, which means that those who shorted the stock have to buy back and return the shares even if doing so makes no sense.